Not many would ever have guessed that the stock market would be up 13% in the middle of a pandemic. Indeed, a 13% return is considered a good year for stocks, let alone one occurring during a year plagued by government shutdowns and social distancing efforts. Is the current valuation warranted? Are the stock market gains sustainable?
Some perspective is helpful. After a good start to the year, stocks fell sharply in February and March as news of the COVID-19 pandemic resulted in economic forecasts being tossed in the scrap heap. Fortunately, the Federal Reserve acted quickly to lower overnight rates to zero and provided support to debt markets using a variety of liquidity measures. Once investors got a sense of the new landscape, they turned to gig economy stocks (think Grubhub, Etsy, Upwork, etc.) and tech stocks.
Investors quickly recognized that the pandemic would force a change in consumer buying patterns due to societal efforts to mitigate the spread of the virus. Spending on home, virtual connectivity, home theaters, and home gyms provided the basis for the rise in stocks like Peloton, Carvana, Square, Shopify, and others. Eventually, the rest of the market also started to recover, though not as strongly as gig economy stocks.
Then, in the fall, markets started to flatline as concerns arose over the upcoming presidential election. Once the election was decided, stocks across all industries marched upward with economically sensitive stocks (small companies and foreign export-oriented companies) getting the biggest bid. Since November 1, the S&P 500 index has zoomed up 12%. As good as this was, it paled in comparison to that of small company and foreign equity markets which were up between 18-24% (to December 10).
All this has led pundits to question whether the stock market is overvalued – they cite the seemingly steady rate of new daily highs and the growth of home-based trading as reasons for caution. It all seems too easy. They also point to valuation ratios that are at multiyear highs. Is the current environment just a knee jerk reaction to the news cycle or are there good fundamental reasons for the market’s exuberance?
First, valuation ratios such as the price-to-earnings ratio (P/E Ratio) tend to rise as economic downturns wear on (chart below). While market prices fall in response to a decline in earnings, they usually do not fall enough to fully offset the impact. Thus, valuation ratios tend to rise – sometimes dramatically. Second, stock markets commonly bid up prices once investors gain better clarity on the pace of earnings recovery. A rule of thumb says investors look out six to nine months. Generally, once the earnings recovery is well underway, valuation levels decline with earnings growth supporting the market.
During this economic downturn, the market has been backed by a Federal Reserve that is committed to keeping overnight lending rates at zero. That additional wrinkle makes stocks more attractive than bonds absent a growing risk of deflation.
While we think there’s good justification for the rise in the stock market, we do have some concerns:
The pandemic continues to worsen, although vaccines are beginning to be administered this week. Even as the near-term economic environment remains uncertain, investors remain confident we will ultimately overcome the pandemic. But getting from A to B may be rocky. We would not be surprised if markets experience episodes of volatility between now and then.
We are apprehensive over the valuations we’re seeing in some corners of the market. Gig economy stocks are all the rage and investors can’t get enough of them. For evidence of this, just look at the pricing of recent IPOs. DoorDash’s IPO was priced at $102, which implies a firm equity value of $72 billion even though this company is only seven years old with reported losses in the hundreds of millions. Investors are willing to overlook that because they love that revenue is growing more than 200% per year. It seems to us that much of DoorDash’s success comes from government mandated shutdowns and social distancing efforts. What does sales growth look like once the pandemic ends? Investors are counting on a permanent change in consumer behavior to justify their faith in the company. Exercise equipment maker Peloton may have seen its user base grow due to the pandemic, but to what extent has demand been brought forward? Isn’t there a real risk that they have converted some customers earlier than they might have if not for the pandemic? Do these stock prices reflect the risk that sales may see a material slowdown?
Despite pockets of what we believe to be irrational exuberance, investors are sending a signal that they believe in nine months, the economic environment will be better than it is today. That justifies the rise we have seen in the markets. While a zero-interest rate environment may increase the risk of getting carried away, we still think that stocks offer long-term value relative to other asset classes, despite the obvious near-term risks.